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Sunday, February 20, 2005

Greenspan's Interest Rate Conundrum

by Calculated Risk on 2/20/2005 06:44:00 PM

Last week, during Greenspan's testimony to Congress, he referred to the behavior of long term rates as a "conundrum". Greenspan's testimony in italics:

"In this environment, long-term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields. The simple mathematics of the yield curve governs the relationship between short- and long-term interest rates. Ten-year yields, for example, can be thought of as an average of ten consecutive one-year forward rates. A rise in the first-year forward rate, which correlates closely with the federal funds rate, would increase the yield on ten-year U.S. Treasury notes even if the more-distant forward rates remain unchanged. Historically, though, even these distant forward rates have tended to rise in association with monetary policy tightening."

Mr. Greenspan is referring to the expectations theory of interest rates were long rates are the geometric average of expected future short rates plus a risk premium that would usually increase with duration of the instrument. This theory assumes that arbitrage between instruments of different durations will set the price.

It is also possible for the risk premium to change over time. As an example, changes in the perceptions of the Fed's credibility on fighting inflation will change the risk premium. For a discussion on the declining risk premium (possibly due to improving Fed credibility), see Dr. Altig's Macroblog.
"In the current episode, however, the more-distant forward rates declined at the same time that short-term rates were rising. Indeed, the tenth-year tranche, which yielded 6-1/2 percent last June, is now at about 5-1/4 percent. During the same period, comparable real forward rates derived from quotes on Treasury inflation-indexed debt fell significantly as well, suggesting that only a portion of the decline in nominal forward rates in distant tranches is attributable to a drop in long-term inflation expectations.

Some analysts have worried that the dip in forward real interest rates since last June may indicate that market participants have marked down their view of economic growth going forward, perhaps because of the rise in oil prices. But this interpretation does not mesh seamlessly with the rise in stock prices and the narrowing of credit spreads observed over the same interval."

Under the expectations theory, a decline in long rates with rising short rates would mean either: 1) the market believes the increase in the short rate is temporary (not really applicable now) or 2) the market believes that economic growth will be slower in the future. Greenspan rejects these explanations and offers the recent rise in the stock market and narrowing of credit spreads as evidence that the economy is healthy. Perhaps the most recent runup in the stock market is just more "irrational exuberance"?

Others have emphasized the subdued overall business demand for credit in the United States and the apparent eagerness of lenders, including foreign investors, to provide financing. In particular, heavy purchases of longer-term Treasury securities by foreign central banks have often been cited as a factor boosting bond prices and pulling down longer-term yields. Thirty-year fixed-rate mortgage rates have dropped to a level only a little higher than the record lows touched in 2003 and, as a consequence, the estimated average duration of outstanding mortgage-backed securities has shortened appreciably over recent months. Attempts by mortgage investors to offset this decline in duration by purchasing longer-term securities may be yet another contributor to the recent downward pressure on longer-term yields.

For an excellent analysis concerning Foreign Central Bank purchases of U.S. instruments, see Roubini and Setser's "Will the Bretton Woods 2 Regime Unravel Soon? The Risk of Hard Landing in 2005-2006." Roubini and Setser suggested that the impact on the interest rates of foreign CBs purchases could be as much as 200 bps. (see here and here) However this is a side point in their excellent analysis of the Current Account Deficit.
Please see: Do Foreign CBs distort the Treasury Yield? Greenspan discounts the impact of these purchases:
"But we should be careful in endeavoring to account for the decline in long-term interest rates by adverting to technical factors in the United States alone because yields and risk spreads have narrowed globally. The German ten-year Bund rate, for example, has declined from 4-1/4 percent last June to current levels of 3-1/2 percent. And spreads of yields on bonds issued by emerging-market nations over U.S. Treasury yields have declined to very low levels.

There is little doubt that, with the breakup of the Soviet Union and the integration of China and India into the global trading market, more of the world's productive capacity is being tapped to satisfy global demands for goods and services. Concurrently, greater integration of financial markets has meant that a larger share of the world's pool of savings is being deployed in cross-border financing of investment. The favorable inflation performance across a broad range of countries resulting from enlarged global goods, services and financial capacity has doubtless contributed to expectations of lower inflation in the years ahead and lower inflation risk premiums. But none of this is new and hence it is difficult to attribute the long-term interest rate declines of the last nine months to glacially increasing globalization. For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum. Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience."

My view: It is probably true that the risk premium has declined and contributed to lower long rates. And Foreign CB purchases might be having an impact on longer rates. But I think the PRIMARY reason for Greenspan's conundrum is that the economy is weaker than it appears. Using GDP growth and unemployment, the US economy is healthy. But the level of debt (both consumer and government), the real estate "boom" that seems based on leverage and loose credit (see Volcker's recent comments), and the poor employment situation (especially the low level of participation) indicate an unhealthy economy. I believe this recovery is being built on a marshland of debt and the bond market is reflecting this weakness.